Here is a detailed guide for investors seeking an understanding of leverage in Forex.
What is Leverage?
Leverage is the borrowing of money from brokers by traders. This money is borrowed to invest in trades. Usually high leverage is offered because of initial margin requirements to invest in trade. Leverage increases the capital investment hundred or more times and allows one to control and trade massive amounts without actually having the amount in hand.
How much Leverage is obtainable?
The amount a broker is willing to loan an investor depends on certain factors like; financial status, trading strategies, risk management and personality. Of course there is flexibility in the amount an investor can loan. Once your broker is satisfied with your details on financial status, account type you are using, strategies you are using for risk management and your personality, you can have huge loans. However one must never forget that any small fluctuations in the price of the currency may lead to equally large gains or losses.
Leverages are given in terms of ratios. For instance, if a trader has a leverage of 100:1, with a deposit of $1,000, the trader can control an amount worth $100,000.
How to Calculate Leverage
There are four simple steps to calculate leverage:
- Determine the total debt (long and short term debts, mortgages and any form of money owed).
- Calculate the total equity of shareholders, if any. This is done by multiplying the number of outstanding shares by stock prices.
- Divide the total debt by the total equity to obtain the financial leverage ratio.
- If the ratio is greater than 2:1, it is a sign of weakness. If the leverage is too high it can be a sign of inevitable bankruptcy.
Leverage Risks
Simply put, the more the leverage, the more the risks. The more the leverage the more the investment and the more the risks attached with every decision you make. There will be decisions to make and when larger leverages are taken, a lot is at stake. You will be under a lot of pressure when large leverages are involved.
If fluctuations are too large, you will face a lot of losses. Most of the time there are risks of bankruptcy when large amounts of leverage are taken by investors. Returning the leveraged amount will even become impossible if investors face losses.
When borrowing from the broker, always do a background check on the broker to make sure they are genuine and cooperative. Some brokers take advantage of people who have little or no knowledge on leverage and its principles.
Benefits of Leverage
For those investors who master the strategies and tools involved in Forex, taking leverages can work out very well. They can predict variations and make the right decisions in good time, making large profits and being very successful investors.
A major advantage of leverage is that the wealth of shareholders’ gets optimized through mixing of debt and equity. This is because interest can be deducted from income when calculating the federal tax liability.
Avoid Greed
For those who are beginning their careers in Forex investment, it is necessary to understand that success may come often, but the risks attached will never cease. With success, do not get tempted to invest very large amounts unless you have enough financial backup to avoid bankruptcy. Always invest small amounts.
The value of currencies keep fluctuating in the market and if you have taken a very large leverage from the broker, once there is depreciation you will lose more than what you invested. This may be a loss for you but will be a great benefit to the broker.